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Today we look at one of most misunderstood parts of auditing: audit risk assessment.

Are auditors leaving money on the table by avoiding risk assessment? Can inadequate risk assessment lead to peer review findings? This article shows you how to make more money and create higher quality audit documentation.

Too often auditors continue doing the same as last year (commonly referred to as SALY)--no matter what. It’s more comfortable than using risk assessment.

But what if SALY is faulty or inefficient?

Maybe it’s better to assess risk annually and to plan our work accordingly (based on current conditions).

Are We Working Backwards?

The old maxim “Plan your work, work your plan” is true in audits. Audits—according to standards—should flow as follows:

Determine the risks of material misstatements (plan our work)

Develop a plan to address those risks (plan our work)

Perform substantive procedures (work our plan)

Issue an opinion (the result of planning and working)

Auditors sometimes go directly to step 3. and use the prior year audit programs to satisfy step 2. Later, before the opinion is issued, the documentation for step 1. is created “because we have to.”

In other words, we work backwards.

So, is there a better way?

A Better Way to Audit

Audit standards—in the risk assessment process—call us to do the following:

Understand the entity and its environment

Understand the transaction level controls

Use planning analytics to identify risk

Perform fraud risk analysis

Assess risk

While we may not complete these steps in this order, we do need to perform our risk assessment first (1.-4.) and then assess risk.

Okay, so what procedures should we use?

Audit Risk Assessment Procedures

AU-C 315.06 states:

The risk assessment procedures should include the following:

​Inquiries of management, appropriate individuals within the internal audit function (if such function exists), others within the entity who, in the auditor's professional judgment, may have information that is likely to assist in identifying risks of material misstatement due to fraud or error

​Analytical procedures

​Observation and inspection

I like to think of risk assessment procedures as detective tools used to sift through information and identify risk.

Just as a good detective uses fingerprints, lab results, and photographs to paint a picture, we are doing the same.

First, we need to understand the entity and its environment.

Understand the Entity and Its Environment

The audit standards require that we understand the entity and its environment.

I like to start by asking management this question: "If you had a magic wand that you could wave over the business and fix one problem, what would it be?"

The answer tells me a great deal about the entity's risk.

I want to know what the owners and management think and feel. Every business leader worries about something. And understanding fear illuminates risk.

Think of risks as threats to objectives. Your client's fears tell you what the objectives are--and the threats.

To understand the entity and its related threats, ask questions such as:

How is the industry faring?

Are there any new competitive pressures or opportunities?

Have key vendor relationships changed?

Can the company obtain necessary knowledge or products?

Are there pricing pressures?

How strong is the company’s cash flow?

Has the company met its debt obligations?

Is the company increasing in market share?

Who are your key personnel and why are they important?

What is the company’s strategy?

Does the company have any related party transactions?

As with all risks, we respond based on severity. The higher the risk, the greater the response.

Audit standards require that we respond to risks at these levels:

Financial statement level

Transaction level

Responses to risk at the financial statement level are general, such as appointing more experienced staff for complex engagements.

Responses to risk at the transaction level are more specific such as a search for unrecorded liabilities.

But before we determine responses, we must first understand the entity's controls.

Understand Transaction Level Controls

We must do more than just understand transaction flows (e.g., receipts are deposited in a particular bank account). We need to understand the related controls (e.g., Who enters the receipt in the general ledger? Who reviews receipting activity?).

So, as we perform walkthroughs or other risk assessment procedures, we gain an understanding of the transaction cycle, but—more importantly—we gain an understanding of controls. Without appropriate controls, the risk of material misstatement increases.

Peer Review Finding

AU-C 315.14 requires that auditors evaluate the design of their client's controls and to determine whether they have been implemented. However, AICPA Peer Review Program statistics indicate that many auditors do not meet this requirement. In fact, noncompliance in this area is nearly twice as high as any other requirement of AU-C 315 - Understanding the Entity and Its Environment and Assessing the Risk of Material Misstatement.

Some auditors excuse themselves from this audit requirement saying, "the entity has no controls."

All entities have some level of controls. For example, signatures on checks are restricted to certain person. Additionally, someone usually reviews the financial statements. And we could go on.

The AICPA has developed a practice audit that you'll find handy in identifying internal controls in small entities.

The use of walkthroughs is probably the best way to understand internal controls.

​As you perform your walkthroughs, ask questions such as:

Who signs checks?

Who has access to checks (or electronic payment ability)?

Who approves payments?

Who initiates purchases?

Who can open and close bank accounts?

Who posts payments?

What software is used? Does it provide an adequate audit trail? Is the data protected? Are passwords used?

Who receives and opens bank statements? Does anyone have online access? Are cleared checks reviewed for appropriateness?

Who reconciles the bank statement? How quickly? Does a second person review the bank reconciliation?

Who creates expense reports and who reviews them?

Who bills clients? In what form (paper or electronic)?

Who opens the mail?

Who receipts monies?

Are there electronic payments?

Who receives cash onsite and where?

Who has credit cards? What are the spending limits?

Who makes deposits (and how)?

Who keys the receipts into the software?

What revenue reports are created and reviewed? Who reviews them?

Who creates the monthly financial statements? Who receives them?

Are there any outside parties that receive financial statements? Who are they?

Understanding the company’s controls illuminates risk. The company’s goal is to create financial statements without material misstatement. And a lack of controls threatens this objective.

So, as we perform walkthroughs, we ask the payables clerk (for example) certain questions. And—as we do—we are also making observations about the segregation of duties. Also, we are inspecting certain documents such as purchase orders.

This combination of inquiries, observations, and inspections allows us to understand where the risk of material misstatement is highest.

Planning Analytics

Multiple-year comparisons of key numbers (at least three years, if possible)

Key ratios

In creating planning analytics, use management’s metrics. If certain numbers are important to the company, they should be to us (the auditors) as well—there’s a reason the board or the owners are reviewing particular numbers so closely. (When you read the minutes, ask for a sample monthly financial report; then you’ll know what is most important to management and those charged with governance.)

You may wonder if you can create planning analytics for first-year businesses. Yes, you can. Compare monthly or quarterly numbers. Or you might compute and compare ratios (e.g., gross profit margin) with industry benchmarks. (For more information about first-year planning analytics, see my planning analytics post.)

Sometimes, unexplained variations in the numbers are fraud signals.

Identify Fraud Risks

In every audit, inquire about the existence of theft. In performing walkthroughs, look for control weaknesses that might allow fraud to occur. Ask if any theft has occurred. If yes, how?

Also, we should plan procedures related to:

Management override of controls, and

The intentional overstatement of revenues

My next post—in The Why and How of Auditing series—addresses fraud, so this is all I will say about theft, for now. Sometimes the greater risk is not fraud but errors.

Same Old Errors

Have you ever noticed that some clients make the same mistakes—every year? (Johnny--the controller--has worked there for the last twenty years, and he makes the same mistakes every year. Sound familiar?) In the risk assessment process, we are looking for the risk of material misstatement whether by intention (fraud) or by error (accident).

One way to identify potential misstatements due to error is to maintain a summary of the larger audit entries you’ve made over the last three years. If your client tends to make the same mistakes, you’ll know where to look.

Now it’s time to pull the above together.

Creating the Risk Picture

Once all of the risk assessment procedures are completed, we synthesize the disparate pieces of information into a composite image.

What are we bringing together? Here are examples:

Control weaknesses

Unexpected variances in significant numbers

Entity risk characteristics (e.g., level of competition)

Large related-party transactions

Occurrences of theft

Armed with this risk picture, we can now create our audit strategy and audit plan (also called an audit program). Focus these plans on the higher risk areas.

How can we determine where risk is highest? Use the risk of material misstatement (RMM) formula.

Assess the Risk of Material Misstatement

Understanding the RMM formula is key to identifying high-risk areas.

What is the RMM formula?

Put simply, it is:

Risk of Material Misstatement = Inherent Risk X Control Risk

Using the RMM formula, we are assessing risk at the assertion level. While audit standards don’t require a separate assessment of inherent risk and control risk, consider doing so anyway. I think it provides a better representation of your risk of material misstatement.

While analytical procedures should occur at the beginning and the end of an audit, this post focuses on planning analytics.

Below I provide the quickest and best way to develop audit planning analytics.

What are Analytics?

If you're not an auditor, you may be wondering, "what are analytics?" Think of analytics as the use of numbers to determine reasonableness. For example, if a company's cash balance at December 31, 2017, was $100 million, is it reasonable for the account to be $5 million at December 31, 2018? Comparisons such as this one assist auditors in their search for errors and fraud.

Overview of this Post

We'll cover the following:

The purpose of planning analytics

When to create planning analytics (at what stage of the audit)

Developing expectations

The best types of planning analytics

How to document planning analytics

Developing conclusions

Linkage to the audit plan

Purpose of Planning Analytics

The purpose of planning analytics is to identify risks of material misstatement. Your goal as an auditor is to render an opinion regarding the fairness of the financial statements. So, like a good sleuth, you are surveying the accounting landscape to see if material misstatements exist.

A detective investigates a crime scene using various tools: fingerprints, forensic tests, interviews, timelines. Auditors have their own tools: inquiry, observation, inspection, analytical procedures. Sherlock Holmes looks for the culprit. The auditor (and I know this isn't as sexy) looks for material misstatements.

The detective and the auditor are both looking for the same thing: evidence. And the deft use of tools can lead to success. A key instrument (procedure) available to auditors is planning analytics.

When to Create Planning Analytics

Create your preliminary analytics after gaining an understanding of the entity. Why? Context determines reasonableness of numbers. And without context (your understanding of the entity), changes in numbers from one year to the next may not look like a red flag--though maybe they should.

Therefore, learn about the entity first. Are there competitive pressures? What are the company's objectives? Are there cash flow issues? What is the normal profit margin percentage? Does the organization have debt? Context creates meaning.

Additionally, create your comparisons of numbers prior to creating your risk assessments. After all, the purpose of the analytical comparisons is to identify risk.

But before creating your planning analytics, you first need to know what to expect.

Developing Expectations

Knowing what to expect provides a basis for understanding the changes in numbers from year to year.

Expectations can include:

Increases in numbers

Decrease in numbers

Stable numbers (no significant change)

In other words, you can have reasons to believe payroll (for example) will increase or decrease. Or you might anticipate that salaries will remain similar to last year.

Examples of Expectations Not Met

Do you expect sales to decrease 5% based on decreases in the last two years? If yes, then an increase of 15% is a flashing light.

Or maybe you expect sales to remain about the same as last year? Then a 19% increase might be an indication of financial statement fraud.

But where does an auditor obtain expectations?

Sources of Expectations

Expectations of changes can come from (for example):

Past changes in numbers

Discussions with management about current year operations

Reading the company minutes

Staffing reductions

Non-financial statistics (e.g., decrease the number of widgets sold)

A major construction project

While you'll seldom know about all potential changes (and that's not the goal), information--such as that above--will help you intuit whether change (or a lack of change) in an account balance is a risk indicator.

The Best Types of Planning Analytics

First, create your planning analytics at the financial statement reporting level. Why? Well, that's what the financial statement reader sees. So, why not use this level (if you can)? (There is one exception in regard to revenues. See Analytics for Fraudulent Revenue Recognition below.)

The purpose of planning analytics is to ferret out unexpected change. Using more granular information (e.g., trial balance) muddies the water. Why? There's too much information. You might have three hundred accounts in the trial balance and only fifty at the financial statement level. Chasing down trial-balance-level changes can be a waste of time. At least, that's the way I look at it.

Second, add any key industry ratios tracked by management and those charged with governance. Often, you include these numbers in your exit conference with the board (maybe in a slide presentation). If those ratios are important at the end of an audit, then they're probably important in the beginning.

Okay, so we know what analytics to create, but how should we document them?

Analytics for Fraudulent Revenue Recognition

AU-C 240.22 says, "the auditor should evaluate whether unusual or unexpected relationships that have been identified indicate risks of material misstatement due to fraud. To the extent not already included, the analytical procedures, and evaluation thereof, should include procedures relating to revenue accounts."

The auditing standards suggest a more detailed form of analytics for revenues. AU-C 240.A25 offers the following:

​a comparison of sales volume, as determined from recorded revenue amounts, with production capacity. An excess of sales volume over production capacity may be indicative of recording fictitious sales.

​a trend analysis of revenues by month and sales returns by month, during and shortly after the reporting period. This may indicate the existence of undisclosed side agreements with customers involving the return of goods, which, if known, would preclude revenue recognition.

​a trend analysis of sales by month compared with units shipped. This may identify a material misstatement of recorded revenues.

In light of these suggested procedures, it may be prudent to create revenue analytics at a more granular level than that shown in the financial statements.

How to Document Planning Analytics

Here are my suggestions for documenting your planning analytics.

Document overall expectations.

Include comparisons of prior-year/current-year numbers at the financial statement level. (You might also include multiple prior year comparisons if you have that information.)

Document key industry ratio comparisons.

Summarize your conclusions. Are there indicators of increased risks of material misstatement? Is yes, say so. If no, say so.

Once you create your conclusions, place any identified risks on your summary risk assessment work paper (where you assess risk at the transaction level--e.g., inventory).

Use Filtered Analytical Reports with Caution (if at all)

Some auditors use filtered trial balance reports for their analytics. For instance, all accounts with changes of greater than $30,000. There is a danger in using such thresholds.

What if you expect a change in sales of 20% (approximately $200,000) but your filters include:

all accounts with changes greater than $50,000, and

all accounts with changes of more than 15%

If sales remain constant, then this risk of material misstatement (you expected change of 20%, but it did not happen) fails to appear in the filtered report. The filters remove the sales account because the change was minimal. Now, the risk may go undetected.

Developing Conclusions

I am a believer in documenting conclusions on key work papers. So, how do I develop those conclusions? And what does a conclusion look like on a planning analytics work paper?

First, develop your conclusions. How? Scan the comparisons of prior year/current year numbers and ratios. We use our expectations to make judgments concerning the appropriateness of changes and of numbers that remain stable. Remember this is a judgment, so, there's no formula for this.

No Risk Identified

Now, you'll document your conclusions. But what if there are no unexpected changes? You expected the numbers to move in the manner they did. Then no identified risk is present. Your conclusion will read, (for example):

Conclusion: I reviewed the changes in the accounts and noted no unexpected changes. Based on the planning analytics, no risks of material misstatement were noted.

Risk Identified

Alternatively, you might see unexpected changes. You thought certain numbers would remain constant, but they moved significantly. Or you expected material changes to occur, but they did not. Again, document your conclusion. For example:

Conclusion: I expected payroll to remain constant since the company's workforce stayed at approximately 425 people. Payroll expenses increased, however, by 15% (almost $3.8 million). I am placing this risk of material misstatement on the summary risk assessment work paper at 0360 and will create audit steps to address the risk.

Now, it's time to place the identified risks (if there are any) on your summary risk assessment form.

If you have thoughts or questions about this post, please let me know below in the comments box. Thanks for reading.

First-Year Businesses and Planning Analytics

You may be wondering, "but what if I my client is new?" New entities don't have prior numbers. So, how can you create planning analytics?

First Option

One option is to compute expected numbers using non-financial information. Then compare the calculated numbers to the general ledger to search for unexpected variances.

Second Option

A second option is to calculate ratios common to the entity’s industry and compare the results to industry benchmarks.

While industry analytics can be computed, I’m not sure how useful they are for a new company. An infant company often does not generate numbers comparable to more mature entities. But we’ll keep this choice in our quiver--just in case.

Third Option

A more useful option is the third: comparing intraperiod numbers.

Discuss the expected monthly or quarterly revenue trends with the client before you examine the accounting records. The warehouse foreman might say, “We shipped almost nothing the first six months. Then things caught fire. My head was spinning the last half of the year.” Does the general ledger reflect this story? Did revenues and costs of goods sold significantly increase in the latter half of the year?

Fourth Option

The last option we’ve listed is a review of the budgetary comparisons. Some entities, such as governments, lend themselves to this alternative. Others, not so–those that don’t adopt budgets.

Summary

So, yes, it is possible to create useful risk assessment analytics–even for a first-year company.

Risk-based audit standards have existed for years, but I still see a resistance to risk assessment procedures. Why? A reliance on the traditional balance sheet audit approach. I think many auditors prefer to test a bank reconciliation (ticking off each cleared transaction) to interviewing the company’s CFO. They enjoy the certainty of vouching payables (yep, the invoice agrees with the payable detail) and disdain the difficulty of walking a transaction through the accounting system. Regardless, many CPA firms struggle to slay the sacred cow of balance sheet audits.

What is a Balance Sheet Audit?

So what is a balance sheet audit approach?

It’s the examination of period-end balance sheet totals (the results of accounting processes) rather than the accounting processes themselves. For example, the auditor might confirm receivables and not perform a walkthrough of billing and collections. The balance sheet audit approach lacks any significant focus on the income statement.

While it is true that nailing down (or “beating up”) the balance sheet provides helpful audit evidence, there are some downsides.

The Downside of Balance Sheet Audits

So what are the weaknesses of a balance sheet audit approach?

First, the balance sheet approach does not address the income statement. Consequently, income statement line items may be misclassified (e.g., expenses netted with revenues). If the balance sheet is correct, net income (the result of revenues and expenses) is correct. But revenues and expenses can still be misclassified. (I once saw grant revenue of $300,000 netted with related grant expenses resulting in a $0 impact to revenues and expenses.)

Secondly, and more importantly, the balance sheet audit method does not address the possibility of theft (and some forms of fraudulent reporting of revenues and expenses). Sure we can confirm cash and reconcile the balance to the general ledger. So what? If someone steals $1 million in cash receipts (or $10 million or whatever number you want to use), the balance sheet approach may not address the risk of theft.

The same is true if the CFO steals money by cutting checks to himself (or to fictitious vendors). The accounts payable balance can be reconciled to a detail, and a search for unrecorded liabilities can be performed–typical balance sheet audit steps–but these procedures don’t address theft.

Finally, audit standards require walkthroughs, fraud inquiries, planning analytics, and an understanding of the business. Without these steps, we cannot truly understand audit risks that lie hidden in accounting processes.

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The Upside of Risk-Based Audits

Understanding the business and its processes requires time, but doing so can lead to a leaner audit. You can decrease some substantive procedures when you know where your risks are. We can also mitigate audit risk (because we know what the risks are).

And this is the beauty and logic of risk-based audits. We determine where the risks are, and then we perform procedures to address those risks. We cease to blindly focus on the balance sheet.

Less time, less risk.

Sounds good to me–but slaying a sacred cow is necessary. I like my steaks medium rare. How about you?

This is a guest post by Harry Hall. He is a Project Management Professional (PMP) and a Risk Management Professional (PMI-RMP). He blogs at ProjectRiskCoach. You can also follow Harry on Twitter.

Some auditors perform the same procedures year after year. These individuals know the drill. Their thought is: been there; done that.

Imagine a partner or an in-charge (i.e., project manager) with this attitude. He does little analysis and makes some costly stakeholder mistakes. As the audit team starts the audit, they encounter surprises:

Changes in the client stakeholders – accounting personnel and management

Changes in accounting systems and reporting

Changes in business processes

Changes in third-party vendors

Changes in the client’s external stakeholders

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Furthermore, imagine the team returning to your office after the initial work is done. The team has every intention of continuing the audit; however, some members are being pulled for urgent work on a different audit.

These changes create audit risks–both the risk that the team will issue an unmodified opinion when it’s not merited and the risk that engagement profit will diminish. Given these unanticipated factors, the audit will likely take longer and cost more than planned. And here’s another potential wrinkle: Powerful, influential stakeholders may insist on new deliverables late in the project.

While we know that an audit walkthrough is an excellent way to probe accounting systems for risk, many auditors aren’t sure how to use this procedure. I hear questions such as:

What is an audit walkthrough?

Will a walkthrough allow me to assess control risk at less than high?

What procedures should I perform?

How many procedures should I perform?

How can I document my walkthroughs?

Should I perform walkthroughs annually?

What transaction cycles merit walkthroughs?

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What is an Audit Walkthrough?

An audit walkthrough is the tracking of a transaction through an accounting system while examining related controls. The purpose of the audit walkthrough is to see if controls exist and are in use (or, as the audit standards say, “implemented”). The results of our risk assessment procedures will illuminate the weaknesses in the accounting system. And we use this information about risk to create our audit plan.

So we do the following:

Identify risk

Assess risk

Create an audit plan to address risk

Walkthroughs fall in the “identify risk” category, and, consequently, are done early in the audit process.

What is not a Walkthrough?

Following a transaction through the system–without reviewing controls–is not an audit walkthrough. We must examine controls to see if they exist and are implemented.

Placing a copy of the operating and accounting system manual in the audit file is not a walkthrough. While such manuals may tell you what the client intends to do, they don’t say what is done. In other words, they don’t answer the implementation question.

Lastly, asking a client, “Is everything the same as last year?” is not a walkthrough. Auditors must do more than inquire.

Will Audit Walkthroughs Allow a Lower Control Risk Assessment?

Usually, audit walkthroughs are not sufficient as support for lower control risk assessments. If the auditor assesses control risk at less than high, she is required to test the effectiveness of the control. Since audit walkthroughs are usually a test of one transaction, they typically don’t validate operating effectiveness. Regarding computer controls, a walkthrough of one transaction might be sufficient to prove effectiveness if general computer controls are working—namely, change control for software. Why? Computer controls—usually—operate consistently.

The purpose of an audit walkthrough is to test for the existence and implementation of controls rather than operating effectiveness. Remember the following:

Focus on implementation of controls — During risk assessment

Focus on effectiveness of controls — When testing controls to support lower control risk

An auditor can determine implementation of controls with a test of one transaction. Effectiveness, on the other hand, usually requires sampling tests—e.g., test of 40 transactions for appropriate purchase orders.

What Procedures and How Many Should I Perform?

There are three key procedures that auditors use in performing walkthroughs:

Inquiry alone is never sufficient in performing risk assessments. So we must marry inquiry with observation and inspection.

The use the three procedures listed above will depend on the transaction cycle you are examining.

Debt Cycle Example

For example, in reviewing the debt cycle, you will usually focus on inquiry and inspection. Why? Well, legal agreements and approvals of debt transactions are key. So I might inspect the following (for example):

Debt agreement

Minutes showing approval of the debt

Approvals of debt service payments

Disbursement Cycle Example

In examining the disbursement cycle, you will typically focus on inquiry, observation, and inspection. My questions might include:

How are purchase orders issued?

What persons issue purchase orders?

Who receives invoices?

What persons approve the payments?

Are checks signed physically or electronically and by whom?

Who reconciles the bank statements?

What persons monitor aged payables (and how)?

As I inquire about the disbursement cycle, I also observe and inspect. Here are some procedures I might perform:

Examine I.T. lists of who can add vendors to the system

Inspect a purchase order to see who approves it

Observe who issues the purchase order (multiple people might release P.O.s)

Inspect an invoice for initials of a department head as approval for payment

Observe who is receiving and approving the invoices

Watch the processing of a check batch (I want to know who can sign checks)

Inspect aged accounts payable detail and one bank reconciliation to determine who reconciles the payables total and bank account to the general ledger

Knowing Which Procedures to Use

You may wonder, “How do I know which procedures to perform?” Ah, that’s the $10,000 question. Always ask, “What can go wrong?” and determine if a control is in place to lessen that threat. That question will drive your risk assessment. The diversity of accounting systems makes it all but impossible to create a checklist that covers all possible issues. What does this mean? You must use your judgment.

Look Beyond the Normal Client Procedures

Always ask who performs the control procedures when key persons are out. Why? An unknown person might have the power to carry out the role. If someone else can—even though they don’t normally—perform a key control procedure, you need to know this. Why? Well, here’s an example of what can happen: If a third person usually does not issue checks but can and that person also reconciles the bank statement, he might issue fraudulent checks. Why? He knows his fraudulent checks will not be detected through the bank reconciliation control.

Always look beyond accounting policies and routine procedures to see what can happen. I often have clients say to me, “John is the only one who approves the purchase orders,” for example. But I know this is not true because purchases would cease to occur when John is out. So I ask, “Who issues purchase orders when John in on vacation?”

More Answers Next Week

We’ll continue our discussion about walkthroughs next week. I still need to answer the following questions:

Today, I provide an overview of why walkthroughs are not just advantageous, but foundational to the audit process.

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What are Walkthroughs?

Walkthroughs are cradle-to-grave reviews of transaction cycles. You start at the beginning of a transaction cycle (usually a source document) and walk the transaction to the end (usually posting to the general ledger). The auditor is gaining an understanding of how a transaction makes its way through the accounting system.

As we perform the walkthrough, we:

Make inquiries

Inspect documents

Make observations

By asking questions, inspecting documents, making observations, we are evaluating internal controls to see if there are weaknesses that would allow errors and fraud to occur. And audit standards do not permit the use of inquiries alone. Observations or inspections must occur.

Some auditors believe that audit walkthroughs (or documentation of controls for significant transaction cycles) are not necessary if the auditor is assessing control risk at high. This is not true. While the auditor can assess control risk at high, she must first gain an understanding of the cycle and the related controls.

Why Audit Walkthroughs?

Accountants are often more comfortable with numbers than processes. We like things that “tie,” “foot,” or “balance.” We may not enjoy probing accounting systems for risk—it’s too touchy-feely. Even so, passing this responsibility off to lower staff is not a good choice. It’s too complicated–and too important. So there’s no getting around it. The walkthrough—or something like it—must be done. Why? You’re gaining your understanding of risks and responding to them. You’re developing your audit plan. Screw up the plan, and you screw up the audit.

What is the purpose of the walkthrough? Identification of risk. Once you know the risks, you know where to audit.

Too often auditors do the same as last year (SALY). And why do we do this?

First, it requires no thinking.

Second, out of fear. We think, “if the audit plan was appropriate last year, why would it not be this year?” In short, we believe it’s safe. After all, the engagement partner developed this approach seven years ago. But is it still safe?

Why SALY is Dangerous

Suppose the accounts payable clerk realizes he can create fictitious vendors without notice, and his scheme allows him to steal over $10 million over a four-year period.

The audit firm has performed the engagement year after year using the same approach. On the planning side, the fraud inquiry and internal control documentation look the same. Walkthroughs have not been performed in the last five years.

On the substantive side, the auditor ties the payables detail to the trial balance. He conducts a search for unrecorded liabilities. He inquires about other potential liabilities. All, as he has done for years. Even so, in current year, the payables clerk walks away with $3 million—and the audit firm doesn’t know it.

Processes matter. And—for the auditor—understanding those processes is imperative.

Why Walkthroughs?

I will say it again: we are looking for risk. Our audit opinion says that we examine the company’s internal controls to plan the audit. The opinion goes on to say that this review of controls is not performed to opine on the accounting system. So, we are not testing to render an opinion on controls, but we are probing the accounting processes to identify weaknesses. And once we know where risks are, we know where to audit.

Check Your Work Papers for Audit Walkthroughs

Pick an audit file or two and review your internal control documentation. Have you corroborated your understanding of the controls by inquiring, inspecting, and observing the significant transaction cycles? Again walkthroughs are not technically required, but the corroboration of controls is. The walkthrough process is an effective way to achieve this objective.

How do you assess the risk of material misstatement? How do you know when to assess inherent risk at high (or low)? Can you assess control risk at high for all assertions? What are significant risks? These are common questions about the risk assessment process.

Understanding these concepts will put money in your pocket and will result in higher quality audits.

Financial Statement Level Risk

Before picking our audit team, we need a general understanding of the entity.

We must understand the business and its control environment to determine risks at the financial statement level (I think of this as the overall risk). The overall risk will dictate our broader responses such as who the audit team will be.

Consider whether the entity has:

Complex transactions

Related party transactions

New accounting pronouncements

Profit pressures

Problem vendor relationships

Going concern issues

Potential debt covenants violations

Cash flow problems

We also need to consider the risk of management override. This threat is always a possibility. If management is playing on the edges, consider how you will add muscle and insight to your audit team—or whether you should even perform the engagement.

Transaction Level Risks

In a previous post, we discussed risk assessment procedures such as walkthroughs, fraud inquiries, and planning analytics. The information gained from those steps is the basis for assessing risk at the transaction level.

Should the transaction risk assessment be performed at the assertion level or for the transaction cycle as a whole? Let’s answer this question by looking at how accounts payable risk might be documented.

If we assess our risk of material misstatement at high for payables (as a whole), what are we saying? That further audit procedures are necessary for all assertions. If we assess risk at high for all payable assertions, and we don’t perform audit procedures in response to the (high) risk assessment, we create an incongruity. We are saying that risk is high for all assertions, but our responses don’t agree.

Wouldn’t it be better to assess risk at the assertion level? For example, if we’ve historically proposed significant journal entries to record additional payables, maybe the risk of material misstatement for the completeness assertion is high. Our audit procedures will include a search for unrecorded liabilities. Now we have an appropriate risk assessment and response (what the audit standards refer to as linkage). The remaining accounts payable assertions could possibly be assessed at low.

Risk of Material Misstatement

We can express the risk of material misstatement (RMM) as:

RMM = Inherent Risk X Control Risk

While audit standards don’t require that we assess inherent risk and control risk separately, it’s helpful to do so. In a moment, we’ll see that inherent risk often drives our audit responses.

Inherent Risk

So what is inherent risk? My simple definition is the risk that exists when no controls are present. (We are not saying controls don’t exist, just that we are disregarding them as we measure inherent risk.)

Inherent risk can be a function of:

The complexity of the transaction (e.g., derivatives are harder to understand)

The nature of the financial statement item (e.g., cash is liquid and subject to theft)

The experience and knowledge of the client’s accounting personnel

Past audit issues in the area

The volume of transactions

As we assess inherent risk, we ask, “what’s the chance that material misstatement will occur assuming there are no related controls?”

Some areas are so risky that the audit standards refer to them as significant risks. These areas require special audit consideration. Significant risks relate to transactions that are complex, nonroutine, or involve judgment. For example, a bank’s allowance for loan losses—due to complexity—demands extra scrutiny. The inherent risk in such areas will always be high.

Now, let’s marry inherent risk with control risk so we can determine our risk of material misstatement.

Control Risk

For audits of smaller entities, control risk is often assessed at high—across the board. Why? To save time. While control risk can’t be assessed at high before performing our risk assessment procedures, we can do so afterward.

Assessing control risk at high is permissible as an efficiency decision. (Risk assessment procedures are still required.)

If control risk is assessed at less than high, the auditor is required to test controls to support the lower risk assessment. It may be more economical to perform substantive procedures rather than testing controls. We might, for example, be able to vouch all of the additions to property and equipment in less time than it takes to test the related controls. If this is true, we will opt to use a substantive approach (vouching all significant additions to invoices), and we will assess control risk at high.

Also, it is possible to have a low to moderate risk of material misstatement if your inherent risk is low—even if your control risk is high. How? Consider the following equation.

Risk of Material Misstatement Formula

IR (low) X CR (high) = RMM (low or moderate)

What does this mean? Well, you can get to a low or moderate RMM without testing controls. Also, you may not need to perform much in the way of substantive procedures–depending on your final RMM for the area.

Plant, Property and Equipment Example

As an example of how this works, think about a low inherent risk assessment regarding plant, property, and equipment.

What’s the inherent risk related to the existence of your client’s main office building? Low.

If your client has no controls related to the existence of the building, would the lack of controls have any bearing on the overall RMM? No.

Do you need to test any controls? No.

Do you need to perform any substantive procedures? Yes, if plant, property and equipment is material. Why? ASC 330.18 says “Irrespective of the assessed risks of material misstatement, the auditor should design and perform substantive procedures for all relevant assertions related to each material class of transactions, account balance, and disclosure.”

Do you need any substantive audit steps (concerning the building) in your audit program? Yes, but it could be as simple as seeing the building (to address the existence assertion).

Call to Action

Consider reviewing your risk assessments, and see if some of the inherent risk assessments will allow you to assess your RMMs at low to moderate–even if control risk is assessed at high.

This is the last in our series of posts about audit risk assessment. Thanks for joining in the journey.

If you have suggestions for other posts, please leave a comment with your idea. Thanks.

You’ve performed your risk assessment procedures, and now it’s time to consider the information you’ve obtained. What are your walkthroughs telling you? Are any variances in your planning analytics begging for attention? What about your fraud inquiries? Are they pointing you in a particular direction?

Now that you see the weaknesses in controls, and you know where your client is most likely to make mistakes, you can plan to address those areas where the risk of material misstatement is most likely to occur.

But before we plan, we need to brainstorm.

Picture is courtesy of DollarPhotoClub.com

Brainstorming

Section 315 of the audit standards requires a discussion among the key engagement team members, including the engagement partner. This discussion is to include an exchange of ideas, often referred to as brainstorming, about where the financial statements might possess a risk of material misstatement due to fraud.

So when should the brainstorming session occur? Logically the “exchange of ideas” follows your risk assessment procedures.

The overall audit sequence is as follows:

We gather information using risk assessment procedures

We discuss the identified risk

We plan our responses

In military battles, soldiers do this same thing. The army sends reconnaissance troops to check the lay of the land and to see where the enemy might lie. Why? To determine how the infantry can move forward most effectively and with the least risk. So soldiers gather information (risk assessment) prior to discussing how to respond (brainstorming). The discussion leads to a battle plan (in our world, the audit plan)

Can you imagine soldiers going into battle without surveying the land and discussing the plan of attack? Yet this what auditors do when we default to a standard audit program. Continuing with the battle analogy, does it make sense to use the same battle plan for every encounter? (We have met the enemy, and he is us.)

Once we discuss the entity’s risks, we know what our greatest threats are.

A Threat

In my last post, I provided an example internal control weakness identified in a walkthrough of accounts payable:

Control weakness: The accounts payable clerk (Judy Jones) can add new vendors and can print checks with digital signatures. In effect, she can create a new vendor and have checks sent to that vendor without anyone else’s involvement.

What’s the threat? Judy can create a fictitious vendor and send checks to herself or an accomplice.

The Response

And what can we do about the risk?

We can print a list of vendors added during the last year and have another person review the list for appropriateness. That other person might be the owner of a small business, a board member in a nonprofit, or the purchasing director in a government. We want a person in the know to review the list for improprieties. Alternatively, we can data mine the vendor addresses for a match with Judy’s home address. There are many ways to address this threat, but my point here is that we need to link our procedures with our identified risk.

Think of the risk assessment process in the following manner:

We perform risk assessment procedures

We assess our risks

We create responses to the identified risks

If we don’t perform risk assessment procedures such as walkthroughs, we may not be aware of risks. If we don’t assess our risks, we may not know what threats are most important. And if we don’t create responses (alter our standard audit plan), then what’s the point of risk assessment? (Surely not to please our peer reviewer.)

Auditing is a holistic art, not a science. Are there formulas? Yes, but if we audit in a formulaic manner (alone), we will miss critical pieces in developing our audit plan. Practice aids (forms) can’t think for us. So I encourage you to use your audit forms, but at some stage, it is good to push them aside and ask:

Am I connecting the dots (understanding the client and the risks inherent in their accounting system)?

Am I determining which risks are most threatening?

Am I creating responses that sufficiently reduce the risk of material misstatement?

My Next Post

Well, we’ve covered much of the risk assessment process, but I still want to take a deeper dive concerning assessing risk at the assertion level and the financial statement level. I’ll do that in my next post in this series.

What can you take away from the above post? Think about your last three audits. After you performed your risk assessment procedures, consider how you altered your audit plan. Do you feel like there is an appropriate linkage between your risk assessment procedures and your audit plan? Are there ways to improve the process?

No appreciable change has occurred in the detection of fraud since the issuance of SAS 99, Consideration of Fraud. Why? I fear the problem lies in how we as auditors use the risk assessment standards.

I still hear auditors say, “we are not responsible for fraud.” But are we not?

Without question, auditing standards require that we perform particular fraud risk assessment procedures. And we also know that the detection of material misstatements—whether caused by error or fraud—is the heart and soul of an audit. So writing off our responsibility for fraud is not an option.

Picture is courtesy of DollarPhotoClub.com

Why Auditors Don’t See Fraud Risk

Why do we not see fraud risks? Here are a few thoughts:

We don’t understand how fraud occurs, so we avoid it

We don’t know how to look for control weaknesses

We think our time is better spent in other areas (namely performing substantive procedures)

We still believe that a balance sheet approach to auditing is all we need

Signs of Weak Risk Assessments

So what are some signs of weak fraud risk assessments?

We ask just one or two questions about fraud

We limit our inquiries to as few people as possible (maybe even just one)

We discount the potential effects of fraud (even after a client tells us it has occurred)

Our files have vague responses to the brainstorming and risk assessment procedures (e.g., “no means for fraud to occur; see standard audit program”)

In effect, some auditors dismiss the fraud risk assessment process. And if we are not aware of fraud risks, we can’t adequately plan our responses. Put another way, if fraud risks are present, and we follow a standard audit program, are we responding to threats?

So how can we understand and respond to fraud risks? Here are a few thoughts.

Start with Potential Fraud Incentives

Fraud comes in two flavors:

Cooking the books (intentionally altering numbers)

Theft

Start your fraud risk assessment process by determining if there are any incentives to manipulate the financial statement numbers. Are there any bonuses or promotions based on profit or other metrics? Are there other potential motivations for playing with the numbers such as promotions? Cooking the books is more prominent in for-profit entities, but be aware that someone nonprofits also offer incentives based on financial statement targets.

Internal control weaknesses are the doorway to theft. Next, we’ll see how to find those defects in accounting systems.

Look for Fraud Opportunities

My go-to procedure in looking for fraud opportunities is to perform walkthroughs. Since accounting systems are varied, and there are no “forms” (practice aids) that capture all processes, walkthroughs can be challenging.

For most small businesses, performing a walkthrough is not that hard. Pick a transaction cycle and start at the beginning and follow the transaction to the end. Note who does what. Inspect the related documents.

Think of the accounting system as a story. Our job is to understand the narrative. As we (attempt to) describe the accounting system, we may find missing pieces. Sometimes we’ll need to go back and ask more questions to make the story flow from beginning to end.

The purpose of writing the storyline is to identify any “big, bad wolves.” The threats in our childhood stories were easy to recognize. Not so in the walkthroughs. It is only in connecting all the dots that the wolves materialize.

Picture is courtesy of DollarPhotoClub.com

Our documentation of the walkthrough should be scalable. If the transaction cycle is simple, the documentation should be simple. If the cycle is complex, provide more detail.

In documenting workflows for complex businesses, the old saying “How do you eat an elephant?” comes to mind. Break complicated systems into pieces, and you will understand them.

Observation of Control Weaknesses

The auditing standards require that we use the following:

Inquiry

Observation

Inspection

Audit standards state that inquiry alone is not sufficient for performing the risk assessment process. So we must marry inquiry with either observation or inspection or inquiry with both observation and inspection. May I suggest that you do the latter? Take pictures of your observations (use your smartphone) and make copies of documents you inspect. I like to write my narrative and then insert images into the “story.” (Tip: You can insert pictures in a Word document by clicking “Insert,” and “Object.” Then browse to the picture you desire to add.)

Our walkthroughs can include:

Narrative

Images

Highlights of control strengths and weaknesses

I summarize the internal control strengths and weaknesses within the narrative and usually highlight the wording. For example:

Control weakness: The accounts payable clerk (Judy Jones) can add new vendors and can print checks with digital signatures. In effect, she can create a new vendor and have a check sent to that vendor without anyone else’s involvement.

Highlighting weaknesses makes them more prominent. Then–when I am done–I can use the identified fraud opportunities to create audit procedures that are responsive.

Fraud-Related Inquiries

Audit Standards (AU-C 240) state that we should inquire of management regarding:

Management’s assessment of the risk that the financial statements may be materially misstated due to fraud, including the nature, extent, and frequency of such assessments

Management’s process for identifying, responding to and monitoring the risks of fraud in the entity, including any specific risks of fraud that management has identified or that have been brought to its attention, or classes of transactions, account balances, or disclosures for which a risk of fraud is likely to exist

Management’s communication, if any, to those charged with governance regarding its processes for identifying and responding to the risks of fraud in the entity

Management’s communication, if any, to employees regarding its views on business practices and ethical behavior

The auditor should make inquiries of management, and others within the entity as appropriate, to determine whether they know of any actual, suspected, or alleged fraud affecting the entity

For those entities that have an internal audit function, the auditor should make inquiries of appropriate individuals within the internal audit function to obtain their views about the risks of fraud; determine whether they have knowledge of any actual, suspected, or alleged fraud affecting the entity; whether they have performed any procedures to identify or detect fraud during the year; and whether management has satisfactorily responded to any findings resulting from these procedures

If management has no method of identifying fraud, might this be an indicator of a control weakness? Yes. It is management’s responsibility to develop control systems to lessen the risk of fraud. It is the auditor’s responsibility to review the accounting system to see if it is designed and operating appropriately.

Notice that in these inquiries, we are not only asking if fraud has occurred but does management have a prevention system in place? And does management communicate these processes to those charged with governance?

Planning Analytics

Another risk assessment procedure is the use of planning analytics. As we compare prior year numbers with current year numbers or as we compare budgeted numbers with current, we may see red flags. You can also use ratios in your hunt for potential risks.

As you review the preliminary numbers, ask, “do these numbers make sense in light of current operations?”

The audit standards state that there is a rebuttable presumption that revenues are overstated. Why? Because many past frauds were carried out by managers intentionally overstating income numbers. In some cases, management posted false journal entries at year-end to inflate income. Then in the following period, the entries were reversed.

Video Concerning Fraud Risk Assessment

Here’s a video about how to perform fraud risk assessments:

Brainstorming and Planning Your Responses – My Next Post

Once you perform your risk assessment procedures, you are ready to brainstorm about how fraud will occur and then plan your audit responses. That’s the topic of our next post—so stay tuned. Subscribe to my blog (it’s free) to ensure that you see the next post (see below).

Consider reading this post again and think about how you useyour audit forms to perform risk assessments. Understanding the process is 90% of the battle.

Windows open. Curtains blowing. The sound of crickets and an occasional train in the distance. It was a simple childhood. It was my childhood. My mother parked her black Ford Falcon and left the keys in the ignition. The doors to our home were unlocked. We trusted our neighbors and they trusted us. And why would we not? We’d known each other forever.

But then one night at the dinner table, my father said, “someone stole Miss Gussie’s Chevy.” Unthinkable. Our innocence was broken, and soon my mother took precautionary measures. Each evening, after parking, she would place the car keys under the car seat. No need to take chances. We began to close the windows at night, but still the back door was left unlocked in case my father needed to go out for a smoke.

A couple of months later, I overheard my mother whispering to my grandmother that a man slithered into Miss Kidd’s house in the dead of night and had taken valuables. Miss Kidd lived diagonally from our home, just a stone’s throw away. To think that someone just walked–unannounced–into the octogenarian’s home. How could this be?

Fear was palpable. Our neighborhood’s character shifted. No longer would Mom leave the keys in the car. No longer would we leave the windows open. No more cricket sounds. And my father even locked the back door.

Safely we would sleep, not because there were no threats, but because of protection.Continue reading

I am the quality control partner for our CPA firm where I provide daily audit and accounting assistance to over 65 CPAs. In addition, I consult with other CPA firms, assisting them with auditing and accounting issues. Read my full bio…